Greece's End Game

Dalibor Rohac

June 22, 2011 2:44 PM

Although Greek prime minister George Papandreou survived a vote of confidence last night, meeting the conditions required by the IMF for the disbursement of another tranche of aid to its ailing economy, parliament will have to pass another austerity package later this month.

But regardless of whether the package is adopted, the Greek government is basically insolvent – in spite of the massive EU bailout and a previous austerity program administered since last year.

It has become fashionable to blame the crisis of the euro on the notorious laid-back life style of the Mediterranean nations. However, ordinary Greeks are the innocent victims, not the perpetrators, in this tragic story. Blame should lie with European political elites for believing that a currency union was a desirable way forward, and for imposing this union on a group of nations as diverse as Finland and Spain. And, of course, a portion of the blame should be attributed to the foolishness of Greek politicians who overlooked the fundamental unsoundness of this monetary arrangement.

The current economic troubles at the eurozone’s periphery do not come as a surprise. Back in the 1990s, many prescient economists, including Milton Friedman and Martin Feldstein, asserted that imposing a single currency on a diverse set of countries was bound to produce fiscal and economic imbalances of the size we see today in Greece or in Portugal.

Former IMF official Desmond Lachman argued last year that the euro’s unraveling will occur on its periphery, when the financing spigots from the EU and the IMF are turned off. And that is precisely what is now occurring.

As the recent S&P downgrade of Greek debt to the CCC category indicates, markets are now taking it as self-evident that Greece will need to default on its debt. The only question is whether that default occurs in the coming weeks –in the case the $17 billion tranche of aid from the EU and the IMF is not forthcoming – or whether Greece will be able to stay afloat for a few more months.

Most of Greek’s public debt has been issued under Greek law. This means that Greece can default unilaterally by merely passing an act of parliament, with no recourse for its international creditors. That can be expected to happen if European politicians refuse to face the reality and do not favor an organized restructuring of Greek debt. Needless to say, the impact of a unilateral, and perhaps chaotic, default on Europe’s fragile banking system is likely to be greater than the effects of moderate restructuring orchestrated by the IMF and the EU.

While the default is inevitable and will solve a part of Greece’s immediate problems, it will address part of the underlying troubles of its economy. Greece suffers from a deep competitiveness problem, having run a current account deficit of around 10 percent of GDP for a number of years. The trade deficit has somewhat narrowed recently, solely due to the rise in commodity prices, which cannot be sustained indefinitely.

To solve its competitiveness problem, Greece will need to leave the euro and devalue its currency significantly to reduce both its wages and export prices. Although European politicians refuse to consider this possibility, Greece has simply run out of alternative, politically feasible ways of boosting its competitiveness.

What would Greece’s exit from the eurozone look like and can it be orderly? At first sight, there are a few seemingly insurmountable obstacles to this course of action. If Greek authorities simply announced that the country would convert all euro-denominated contracts into drachmas, the country’s banking system would receive a severe blow, and a massive capital outflow would occur.

Yet, that does not need to happen. After all, history offers us examples of relatively painless dissolutions of monetary unions – the former USSR or the Austro-Hungarian experiences, for example. The conversion could occur as a policy surprise: the Greek government could suddenly declare a two-week banking holiday and impose temporary capital controls. Converting banking deposits into a new currency is a trivial task, as would be the conversion of Greek-issued public and private debt into drachmas. Likewise, euro notes in circulation can be stamped reasonably quickly and easily.

A substantial devaluation of the drachma would boost both the tourism industry and the exports, thereby enabling the government to pursue a program of fiscal and economic reforms without pushing the country into a further recession.

European leaders might choose – as they have done in the past – to ignore these basic economic lessons and continue trying to keep an insolvent Greece afloat. Yet to really help this maritime nation, a structured default is necessary. Indeed, an orderly default is possible and such an end game need not be the metaphorical capsize envisaged by many. Only then can the bigger game – making Greece competitive again – really begin.

Dalibor Rohac is a research fellow at the Legatum Institute in London.